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The Pizza Shoppe has debt with both a face and market value of $24,000 and a...

The Pizza Shoppe has debt with both a face and market value of $24,000 and a coupon rate of 6.4 percent. The expected earnings before interest and taxes are $21,400, the tax rate is 35 percent, and the unlevered cost of capital is 11.4 percent. What is the firm's cost of equity?

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Answer #1

The earnings before interest and tax(EBIT) of unlevered firm is same earnings before tax(EBT).

Unlevered value of firm = EBT*(1-tax rate) /Unlevered cost of capital

= $21400*(1-0.35) / 0.114

= $13910 / 0.114

= $122017.54

Value of Levered firm = Value of unlevered + tax*Debt

= $122017.54 + 0.35*$24000

= $130417.54

Value of levered firm = Value of Equity + Value of Debt

Value of Equity = Value of levered firm - Value of Debt

Value of Equity = $130417.54 - $24000

= $106417.54

Cost of Equity(re) = r0 + (r0 - rd)*(1-Tax rate)*(D/E)

Where, r0 is unlevered cost of firm

rd is cost of Debt

D/E is debt to equity ratio

Therefore, re = 11.4 + (11.4-6.4)*(1-0.35)*(24000/106417.54)

= 11.4 + 5*0.65*(24000/106417.54)

= 12.13%

Firm's cost of equity is therefore = 12.13%

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